T.C. MEMO 2014-107 (2014).
Bross Trucking is a fascinating case from an estate planning perspective because it presents facts that occur frequently in the representation of family businesses and the planning issues confronting the entrepreneur. In estate planning for families, advisors often encounter circumstances where the family business is growing, either geographically or by branching into other related lines. Maintaining the growth in the name of the senior family member can increase the estate for the senior family members, assuming the ventures are successful. Where multiple generations of the family are involved, it is common to find that the senior members want to assume less risk than would be involved in expansion. However, the junior members may be more willing to undertake the risk in favor of the expansion and potential gains.
In Bross Trucking, the patriarch of the family was Chester Bross who had entered the road construction industry in 1966 and in 1972 created a variety of construction corporations to provide road construction work in Missouri, Illinois, and Arkansas. Mr. Bross was extremely successful with construction and as time passed, he began to branch out into other related lines of work. In 1982, he organized “Bross Trucking” which was a company engaged in hauling construction related materials for road construction projects. The principal customers of Bross Trucking were a variety of family related construction entities, but Bross Trucking did not have any formal written agreements between the related parties. Other related parties were owned by Mr. Bross, his wife, or his sons who had entered the business to work with him.
In the late 1990s, Bross Trucking encountered a series of regulatory issues related to the trucking company operations and it soon began receiving “unsatisfactory” ratings. In July 2003, Mr. Bross and his three sons met with an attorney and it was agreed that they would organize a new trucking company called “LWK Trucking” that began doing the trucking formerly done by Bross Trucking. At the outset, it used the Bross Trucking equipment which still displayed Bross Trucking logos. However, because of the “badwill” associated with Bross Trucking, the LWK Trucking managers (e.g., Mr. Bross’s sons) needed to cover up the “Bross Trucking” signs on the trucks. One of the important aspects of the case is that 50% of the employees of the new company had previously worked for Bross Trucking, however, the Court did not view this fact as a transfer of a “work force in place” both because the company offered new lines and the Court noted that they may have been independent contractors. Mr. Bross was not engaged in the new venture.
The IRS challenged this plan on two grounds. First, they argued that there was a distribution of corporate goodwill from Bross Trucking to Mr. Bross followed by a gift of the goodwill to the sons for the creation of LWK Trucking. In the event that there had been a distribution of corporate goodwill, there would have been a taxable event. However, the facts illustrate that Mr. Bross did not have an employment agreement or covenant not to compete with Bross Trucking. Certainly, it was true that the relationships were created because of Mr. Bross’ personal position, but there was no evidence that it was Mr. Bross’ personal relationships as the sons were similarly close to Bross Trucking’s customers (of course, they were other family members!).
Historically, it has been difficult for the IRS to challenge the “gift of corporate opportunity” albeit, it arises in a variety of settings in general practice. The famous case on the distribution of corporate goodwill is in a case called Martin Ice Cream Co. v. Commissioner 110 T.C. 189 (1998). In Martin Ice Cream Co., the corporate entity distributed ice cream products including Haagen Dazs ice cream to supermarkets. The controlling shareholder had personal relationships with its customer and the corporation sold its distribution rights to a wholly owned subsidiary of Haagen Dazs along with business records, customer records and associated goodwill. The Commissioner argued that the Company should be taxed on the gain from the sale of the goodwill. However, the Court held that the customer relationships and distribution rights were the shareholder’s personal assets and not company assets. Thus, Martin Ice Cream Co. decision stands for the position that the shareholder can possess ‘goodwill’ type rights personally that can be sold to a buyer, without impact on the company/employer.
A contrary case on goodwill was Solomon v. Commissioner T.C. Memo 2008-102 (2008) where the court found that the goodwill was, in fact, developed by the company. Solomon found that the ‘goodwill’ type rights could be either personal to the shareholder/employee or developed by the Company as a corporate asset. In Solomon, the court had found that the corporate entity had received funds in exchange for a customer list and that the shareholders had not received any payment for the customer list, contrary to the agreement. Solomon distinguished the Martin case on three grounds. First, the company in questions, Solomon Colors, had a business of processing, manufacturing and sales rather than one of personal services. Thus, it did not depend entirely on the goodwill of its employees for its success. Second, the shareholders were not sellers of an asset in their individual capacity. Third, the buyer required noncompete agreements, but not employment or consulting agreements with the selling shareholders making it unlikely that they were purchasing the personal goodwill of these individuals. Accordingly, in Solomon, the Court held that the amounts potentially allocable to the customer list was actually attributable to their covenant not to compete.
The Bross Trucking court describes circumstances where personal goodwill can be owned by the shareholders or as corporate goodwill and concluded that Bross Trucking could not transfer goodwill to Mr. Bross in this case. As a factual matter, the court found that any goodwill was Mr. Bross’s goodwill and that there was no work force in place that could be transferred. Further, the court found factually that there was no evidence that Bross Trucking transferred any other intangible assets to Mr. Bross.
Having concluded that there was no distribution of corporate goodwill, the Court then found that there could be no further gift. One can quarrel with whether the Court found that there was no goodwill transfer from Bross Trucking to Mr. Bross or whether there was no value to the transfer. Because Mr. Bross did not have a covenant not to compete with Bross Trucking, any relationship issues were owned personally by Mr. Bross. Moreover, the Court found that “goodwill” from the corporate name was not a factor due to regulatory and “badwill” issues. Finally, the Court discounted the IRS argument that there was a transfer of a work force in place from the corporation to Mr. Bross. Bross Trucking has been criticized as inconsistent because the fact that the corporation made no distribution to Mr. Bross did not necessarily determine whether Mr. Bross transferred his personal goodwill to the new company. However, the same can be said about Mr. Bross’ relationship with LWK Trucking as Bross Trucking. Mr. Bross had no relationship with the new entity and did not sign a covenant not to compete with the new entity. Even if he had signed a covenant not to compete with the new entity, presumably, there would have been some form of compensation paid for that agreement. It could have been difficult for the IRS to negate the sufficiency of consideration paid in such a contract.
While the Court could have provided greater analysis on the secondary issue of whether the parent made a gift to the child’s newly created entity, it was dismissed out of hand after finding that there was no corporate distribution (because Mr. Bross already owned goodwill). However, in this author’s view, the Court would have been further obligated to find other business relationships with the new entity which would have linked Mr. Bross to LWK such as a covenant not to compete, consulting agreement or other employment arrangement.
An ancillary issue set forth in the facts of Bross Trucking, but never addressed by the decision, was the fact that the newly created entity, LWK Trucking, had the majority of the shares held, not by the sons directly, but by Roth IRAs set up for the sons. The Court mentions this factor but it is either not challenged by the IRS or, perhaps it was addressed in a separate proceeding involving the sons. Having a business entity in which the family has an interest held by a retirement account raises thorny self-dealing issues. However, the practice must be somewhat common as in September, 2014, the Government Accountability office reported that at the end of 2011, 314 taxpayers held more than $25 million in their retirement accounts! Surprisingly, the $81 billion gross sum represents an average of $250 million among the group! For an account balance to balloon to $250 million in value, there would have had to have been certain situations where there was this type of planning. Even if someone had $1,000,000 in an account in 1974, it would have had to have doubled every five years to have $250 million in 2014. Nevertheless, it is just a sidelight of the opinion.
The Bross Trucking case is important in estate planning as it presents a commonly encountered circumstance where the other family members begin dealing in related entities. It is not uncommon for family ventures to have related entities. For example, real estate developers discuss the intangible “know how” to family relations and they can allow new development opportunities to occur in the name of other (presumably younger) heirs. This concept has typically been a valuation issue. For example, suppose a father is engaged in a legal practice and upon graduating from law school, a father refers a new matter to the newly licensed son as counsel. How would the IRS attack this venture from a transfer of goodwill “know how” or opportunity?
In two law review articles, it was concluded that this type of transfer would be too difficult for IRS attack. From a gift tax perspective there is little or no legal authority that “gift of [an] opportunity” is a taxable gift. This academic issue has been addressed in two law review articles. George Cooper, A Voluntary Tax New Perspectives on Sophisticated Estate Tax Avoidance, 77 Colum. L. Rev. 161 (Mar. 1977) (hereafter “Cooper”); Randall J. Gingiss, The Gift of Opportunity, 41 DePaul L. Rev. 395 (Winter 1992). Gingiss states that there is “little statutory authority directly bearing on the issue [of taxing gifts of services and opportunity, but] there has been a sporadic history of cases that test the outer limits of the gift tax statutes.” Id. at 395. Gingiss then devotes the first part of the article to summarizing the statutory and judicial developments to date and concludes that “[i]n sum, the Service’s attempts to reach gifts of opportunity under the gift tax have [been] met with mixed success. The Service, however, had a certain degree of success in its attempts to tax the gift of the use of the property. Of greatest import is that non-property transfers, such as the transfer of business contracts, generally escape the gift tax system.” Id. at 416.
Bross Trucking represents another loss for the Service in attempts at the theory. The legal authority surrounding the issue is based upon Crowley v. Commissioner, 34 T.C. 333 (1960). Crowley deals with assignment of income in a partnership setting but it predates the enactment of Section 704(e) of the Internal Revenue Code. It stands for a pro-taxpayer position that income is not to be attributed to the parents. In sum, a fairly common factual setting has resulted in little or no case challenge until Bross Trucking this year.
A closer reading of the case leads one to the conclusion that the existence of, or lack of, a covenants not to compete is a critical issue in determining whether a transfer of goodwill has occurred. One common circumstance where covenants are prevalent is in the medical community. Many physician practices mandate that the partners execute employment agreements and covenant not to compete in order to protect the “corporate goodwill” of a practice which could have been traditionally personal goodwill to the physician. It is not uncommon for medical practices to disband and for the physicians, rather than formally liquidate the “Old Co,” to merely reaffiliate elsewhere with new covenants not to compete, consulting agreements and employment contracts. Could the IRS assert that there are dividend and/or gift issues associated with such transactions when the transaction is normally in a “arm’s length” deal?
Could it be viewed that, while no distribution of goodwill was made from Bross Trucking to Mr. Bross, he still, nevertheless, made a gift of his personal goodwill to LVK Trucking? One of the key determining factors related to the lack of corporate goodwill was that there were no contract in place to tie Mr. Bross to Bross Trucking. Similarly, there was no contract with Mr. Bross and his son’s corporation, LVK. He did not work for LVK, even as a consultant. As such, it would be hard to place a value on a “transfer” in this circumstances where the relationship between the child’s corporation and the parent is so indirect.
A later case in 2014 involving corporate or personal goodwill was Estate of Adell v Commissioner, TC Memo 2014-155 (2014) which addressed the issue from a different angle. In Adell, a family dispute erupted after the patriarch, Franklin Adell, passed. Franklin owned STN.com where he and his son, Kevin both worked. They had formed a non profit religious radio network “Spread the Word” distributed by STN.com, apparently at a handsome profit. This case addresses the value of STN.com in Franklin’s estate and revealed that the facts showed that the goodwill in question was actually the son’s goodwill, not that of the corporation.
Adell is a continuation after two earlier reported cases, TC Memo 2013-228 (dealing with I.R.C. §6166 where the estate failed to make timely payments) and TC Memo 2014-89 (again dealing with payments made under I.R.C. §6166). This case is eye opening for a variety of issues not only related to the family disputes, but also related to a relationship between the nonprofit and for profit entity. This case does not address the nonprofit concerns, but the Court referenced in a footnote whether the IRS may eventually revoke the exempt status of the nonprofit in light of the circumstance.
In Adell, the taxpayer originally provided a return value based upon discounted cash flow reduced by an economic charge for Kevin (the son’s) personal goodwill. The IRS issued a “Notice of Deficiency” that was ten times higher and the taxpayer amended its position equal to 50% of the value originally returned. The Court concluded that the original returned value was an admission against an interest by the estate and ultimately, concluded that the IRS’ valuation expert was “not persuasive” in the assessment of Kevin’s goodwill. In other words, Kevin had key contacts, trust with ministers who provided programming for the nonprofit and he had no covenant not to compete or employment agreement. This was considered crucial in determining the value of the entity because it should be reduced for determining the value of “for profit” STN.com entity included in the father’s estate. Query: perhaps the family relationships should not be memorialized in a covenant not to compete in order to allow for discounts as were permitted in the Adell case. There have been prior circumstances where a “key person” discount was permitted and this case continues as support for the existence of a “key person” discount.
Another 2014 case showed us that, as with everything, there are limits. Said another way, Cavallaro v. Commissioner, TC Memo 2014-189 illustrates that you cannot recreate a tax plan arbitrarily after the fact. Cavallaro presents an IRS challenge that a corporate merger resulted in a gift by parents to their sons.
With Cavallaro, mom and dad, William and Patricia, owned a machine shop called Knight Tool. In the early 80s, their three sons joined them in working for the business. In or around 1982, William, their son Ken, and the Knight engineers created a liquid dispensing machine called Cam/Alot. In 1986, Knight sought advice on marketing Cam/Alot and in early 1987, Knight was advised not to spin off the Cam/Alot business from the machine shop because of thin capitalization problems for the corporation and significant debt obligations.
In late 1987, the three sons created their own corporation, Camelot Systems Inc with just $333 each. There was no document that transferred ownership of the liquid dispensing machine and, notwithstanding the fact that the brothers made different contributions to the new company, all three valued their interests the same. Ken Cavallaro continued to work on the Knight payroll and with Knight engineers to improve the machine. The trial testimony presented in the case was that the dad, William, gave the Camelot corporate book to Ken with words that conveyed a transfer of ownership.
While there were two corporations created, they operated together. There were no separate set of books for Camelot, the transactions for Camelot were recorded on Knights books by journal entry there was no consistent means of allocating the income between companies. There was a “shared payroll” and the companies had a joint financing agreement for the significant corporate debt. A significant key fact found by the Court was that Knight, not Camelot Systems, owned the technology for the machine. Once the Cam/Alot machine was to be marketed there was contractual arrangement where Knight manufactured the Cam/Alot machines and Camelot sold and distributed them to third parties. Nevertheless, the Knight accountants determined that Knight (not Camelot) was eligible for the research and development tax credit.
In October 1994, the Cavallaros engaged an estate planning firm to give estate planning advice. Their counsel reviewed the Cavallaros estate and businesses and observed that there would be benefits of passing the business (i.e., Knight) in a tax efficient manner to the sons. Mr. Hamel (the estate planning lawyer) testified to the fact that because Mr. Cavallaro had handed the Camelot minute book to Ken Cavallaro at a 1987 estate planning conference, it should support the plan that the technology and businesses were owned by Camelot. However, because there was no contemporaneous documentation, Mr. Hamel suggested that the family prepare “confirmatory” bills of sale to document transfers which would have separated Camelot from Knight. The Court opinion makes clear that there was confusion between the accountants and estate planning counsel and it did not seem that the “team” was together. The accountants were advised to amend prior income tax returns related to the research and development credit.
Why were the 1994 steps taken with regard to separation of Camelot from Knight? In 1995, Camelot and Knight considered merger of the two companies. The accountants engaged to value the entities found that Knight’s portion of the total $70-75 million dollar value was just $13 to $15 million. Thus, a merger occurred on December 31, 1995 whereby Mr. and Mrs. Cavallaro received 18% or 19% percent of the value of the continuing entity and the sons received stock worth 81% of the continuing entity. Thereafter, on July 1, 1996, the merged companies were sold for $57 million in cash together with additional potential benefits of another $43 million in deferred payments. In the end, the parents were to receive $10 million and the sons were to receive $15 million each.
The Cavallaro case illustrates a factual scenario where the IRS raised questions about not only the income tax consequences, but also gift tax consequences to the merger. Noting that the taxpayers must carry the burden of proof, the Court concluded that there was a lack of an arm’s length transaction in the dealings between the parties and the question of valuation is a question of fact. Accordingly, the Court concluded that the parents were not paid full and adequate consideration and had made a $29.6 million gift to their sons. However, because they followed professional advice they had reasonable cause for failing to file a gift tax return and were not liable to penalties or accuracy related penalties.
While the Cavallaro case illustrate how not to plan an estate, it could also be a function of the possibility that bad facts make bad law. It could also be viewed as a situation of bad lawyering. Perhaps there is more to the case than the Court recited in the recitation of “facts,” but if the sons had, in fact, started their own company, paid for the development, accounted for the separate companies and hired the parents company to build the machine, the result could likely have been different. Cavallaro also stands for the proposition that the estate planning team needs to work together.
In sum, the two law review article, cited above, reveal that transfers of “opportunity” are difficult for the IRS to attack. Careful long range planning together with proper and appropriate documentation can achieve common family goals. Often, the senior members want to assume less risk than would be involved in business expansion and the junior members want to undertake the risk for possible entrepreneurial gains. It is important for estate planners to remember these factors in counseling their clients.
Glenn A. Henkel is a shareholder in the firm and earned his J.D. degree at Rutgers University School of Law, where he graduated with honors and was awarded the Prentice Hall Award for outstanding performance in the area of taxation. He earned his LL.M. in Taxation at New York University. Mr. Henkel’s particular areas of expertise include complex estate planning, tax-exempt organizations and Probate, Trust and Estate Law.